Financeint 2005 complete


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Financeint 2005 complete

  1. 1. Vault Guide to Finance Interviews is made possible through the generous support of the following sponsors:
  2. 2. The media’s watching Vault!Here’s a sampling of our coverage.“For those hoping to climb the ladder of success, [Vaults] insightsare priceless.”– Money magazine“The best place on the web to prepare for a job search.”– Fortune“[Vault guides] make for excellent starting points for job huntersand should be purchased by academic libraries for their careersections [and] university career centers.”– Library Journal“The granddaddy of worker sites.”– U.S. News & World Report“A killer app.”– New York TimesOne of Forbes 33 “Favorite Sites”– Forbes“To get the unvarnished scoop, check out Vault.”– SmartMoney Magazine“Vault has a wealth of information about major employers and job-searching strategies as well as comments from workers about theirexperiences at specific companies.”– The Washington Post“A key reference for those who want to know what it takes to gethired by a law firm and what to expect once they get there.”– New York Law Journal“Vault [provides] the skinny on working conditions at all kinds ofcompanies from current and former employees.”– USA Today
  4. 4. Copyright © 2005 by Vault Inc. All rights reserved.All information in this book is subject to change without notice. Vault makes no claims as tothe accuracy and reliability of the information contained within and disclaims all warranties.No part of this book may be reproduced or transmitted in any form or by any means,electronic or mechanical, for any purpose, without the express written permission of Vault Inc.Vault, the Vault logo, and “The Most Trusted Name in Career InformationTM” are trademarksof Vault Inc.For information about permission to reproduce selections from this book, contact Vault Inc.,150 W. 22nd Street, 5th Floor, New York, New York 10011-1772, (212) 366-4212.Library of Congress CIP Data is available.ISBN 1-58131-304-7Printed in the United States of America
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  6. 6. Table of ContentsINTRODUCTION 1 Landing a Gig . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2THE FINANCIAL SERVICES INDUSTRY 5 The Finance Interview: An Overview . . . . . . . . . . . . . . . . . . . . . . .6 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12VALUATION TECHNIQUES 19 How Much is it Worth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Basic Accounting Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Market Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Discounted Cash Flow (DCF) . . . . . . . . . . . . . . . . . . . . . . . . . . . .28 Comparable Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 Multiple Analysis or Comparable Company Analysis . . . . . . . . .45 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47EQUITY ANALYSIS AND PORTFOLIOMANAGEMENT 61 Investment Management and Portfolio Theory . . . . . . . . . . . . . . .62 Stock Analysis and Stock Picking . . . . . . . . . . . . . . . . . . . . . . . . .64 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .67STOCKS 71 Equity vs. Debt (Stocks vs. Bonds) . . . . . . . . . . . . . . . . . . . . . . . .72 Stock Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .77 Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY ix
  7. 7. Vault Guide to Finance Interviews Table of ContentsBONDS AND INTEREST RATES 83 Bond Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84 Pricing Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86 The Fed and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89 The Fed and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91 Effect of Inflation on Bond Prices . . . . . . . . . . . . . . . . . . . . . . . .92 Leading Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . .93 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93CURRENCIES 99 Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 Influence of Interest Rates on Foreign Exchange . . . . . . . . . . . .101 Influence of Inflation on Foreign Exchange . . . . . . . . . . . . . . . .102 Capital Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . .103 Exchange Rate Effects on Earnings . . . . . . . . . . . . . . . . . . . . . .104 Effect of Exchange Rates on Interest Rates and Inflation . . . . .105 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106OPTIONS AND DERIVATIVES 109 The Wild West of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110 Writing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112 Options Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .113 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .116 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .117 Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY xi
  8. 8. Vault Guide to Finance Interviews Table of ContentsMERGERS & ACQUISITIONS 121 Why Merge? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122 Why Not Merge? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123 Stock Swaps vs. Cash Offers . . . . . . . . . . . . . . . . . . . . . . . . . . . .124 Tender Offers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 Mergers vs. Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Will That Be Cash or Stock? . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Accretive vs. Dilutive Mergers . . . . . . . . . . . . . . . . . . . . . . . . . .128 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129BRAINTEASERS AND GUESSTIMATES 133 Stress Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .134 Acing Guesstimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .134 Brainteasers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137FINAL ANALYSIS 147APPENDIX 149 Finance Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150 About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .158 Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY xiii
  9. 9. Decrease your T/NJ Ratio (Time to New Job)Use the Internet’s most targetedjob search tools for financeprofessionals.Vault Finance Job BoardThe most comprehensive and convenient job board for financeprofessionals. Target your search by area of finance, function,and experience level, and find the job openings that you want.No surfing required.VaultMatch Resume DatabaseVault takes match-making to the next level: post your resumeand customize your search by area of finance, experience andmore. We’ll match job listings with your interests and criteriaand e-mail them directly to your inbox.
  11. 11. Vault Guide to Finance Interviews Introduction Landing a Gig Money makes the world go round, and those in charge of money are the financiers. Have thirst for relevance? The finance industry has always been a competitive field, due in large part to the glamour and prestige assigned to the working relationships with industry titans. Of course, the outstanding salaries explain much of the pull as well. (Unless you can dunk a basketball or throw football 50 yards, it’s hard to beat the pay in investment banking, where recent college grads can come close to six figures.) So what’s the secret to landing a finance gig? Naturally, identifying opportunities is the first step. Many finance firms have structured on-campus recruiting processes. If you’re in college or graduate school (especially business school), check with the career services office to see which finance companies recruit at your campus. If the company you’ve got your eye on doesn’t come to your school, don’t despair. Many firms accept resumes from non-targeted schools. Check the firm’s web site to find out how to submit your resume. Firm web sites are also a good bet for those out of school looking to change jobs or careers. Additionally, check with friends and alumni for openings at a specific firm or in the finance industry in general. Virtually every recruiter or professional agrees that no matter how you hear about your position, the most important factor in getting a job is making a good impression in your interview. No matter what your credentials, experience or references, if you don’t come off in your interviews as someone who can do the job and who will fit in at the company, you stand little to no chance of getting hired. Don’t be too put off by the pressure. If you’ve landed an initial interview, you can assume someone at the firm, in reviewing your resume, thinks you’ve got at least the basics necessary to succeed. It’s now up to you to prove that to your interviewers by being confident and knowledgeable. This guide will familiarize you with the questions you’re likely to receive in the course of your interview. As you’ll see, you can expect to tested to make sure you can work under pressure, fit into the company’s culture and excel in your job. Finance career opportunities can be broadly divided into several categories, most prominently investment banking, commercial banking, asset management, venture capital and private equity, and finance positions at a corporation like Dell or The Coca-Cola Company (also referred to as “corporate finance”). There is considerable movement between these positions — I-bankers leave to take posts in industry, or with private equity firms, etc. Generally, the pinnacle for most finance professionals is either as a partner or managing director of a bank, a CAREER2 LIBRARY © 2005 Vault Inc.
  12. 12. Vault Guide to Finance Interviews Introductionportfolio manager for an asset management firm, or as Chief Financial Officer(CFO) of a company. The interviews for each of these industries are very similar. For more information on finance interviews and finance careers, go to the Vault Finance Career Channel • Employer surveys on hundreds of top finance employers • The Vault Guide to Advanced and Quantitative Finance Interviews and the Vault Finance Interviews Practice Guide • Thousands of top finance jobs on the Vault Finance Job Board • Finance Resume Review and Writing – named the “Top Choice” for resume makeovers by The Wall Street Journal • One-on-one finance interview prep with Vault finance interview experts • The Vault Guide to the Top 50 Banking Employers, the Vault Career Guide to Investment Banking, the Vault Career Guide to Hedge Funds, the Vault Career Guide to Investment Management, and other Vault finance guides Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 3
  13. 13. Wondering what its like to work at a specific employer?3M | A.T. Kearney | ABN Amro | AOL Time Warner | AT&T | AXA | Abbott Laboratorie Accenture | Adobe Systems | Advanced Micro Devices | Agilent Technologies | Alconc. | Allen & Overy | Allstate | Altria Group | American Airlines | American ElectriPower | American Express | American International Group | American Managemen Read what EMPLOYEES have to say about:Systems | Apple Computer | Applied Materials | Apria Healthcare Group | AstraZenecaAutomatic Data Processing | BDO Seidman | BP | Bain & Company | Bank One | Bank o • Workplace cultureAmerica | Bank of New York | Baxter | Bayer | BMW | Bear Stearns | BearingPointBellSouth | Berkshire Hathaway | Bertelsmann | Best Buy | Bloomberg | Boeing | Boo • CompensationAllen | Borders | Boston Consulting Group | Bristol-Myers Squibb | Broadviewnternational| Brown Brothers Harriman | Buck Consultants| CDI Corp.| CIBC Worl • HoursMarkets | CIGNA | CSX Corp| CVS Corporation | Campbell Soup Company| Cap GeminErnst & Young| Capital One | Cargill| | Charles Schwab | ChevronTexaco Corp. | Chiquit • DiversityBrands International | Chubb Group | Cisco Systems | Citigroup | Clear Channel | ClifforChance LLP | Clorox Company | Coca-Cola Company | Colgate-Palmolive | Comcast • Hiring processComerica | Commerce BanCorp | Computer Associates | Computer ScienceCorporation | ConAgra | Conde Nast | Conseco | Continental Airlines | CorningCorporate Executive Board | Covington & Burling | Cox Communications | Credit SuissFirst Boston | D.E. Shaw | Davis Polk & Wardwell | Dean & Company | Dell ComputerDeloitte & Touche | Deloitte Consulting | Delphi Corporation | Deutsche Bank | DeweBallantine | DiamondCluster International | Digitas | Dimension Data | Dow ChemicalDow Jones | Dresdner Kleinwort Wasserstein | Duracell | Dynegy Inc. | EarthLinkEastman Kodak | Eddie Bauer | Edgar, Dunn & Company | El Paso CorporationElectronic Data Systems | Eli Lilly | Entergy Corporation | Enterprise Rent-A-Car | Erns& Young | Exxon Mobil | FCB Worldwide | Fannie Mae | FedEx Corporation | FederaReserve Bank of New York | Fidelity Investments | First Data Corporation | FleetBostoFinancial | Ford Foundation | Ford Motor Company | GE Capital | Gabelli AsseManagement | Gallup Organization | Gannett Company | Gap Inc | Gartner | GatewayGenentech | General Electric Company | General Mills | General Motors | GenzymeGeorgia-Pacific | GlaxoSmithKline | Goldman Sachs | Goodyear Tire & Rubber | GranThornton LLP | Guardian Life Insurance | HCA | HSBC | Hale and Dorr | HalliburtonHallmark | Hart InterCivic | Hartford Financial Services Group | Haverstick ConsultingHearst Corporation | Hertz Corporation | Hewitt Associates | Hewlett-Packard | HomDepot | Honeywell | Houlihan Lokey Howard & Zukin | Household International | IBMKON Office Solutions | ITT Industries | Ingram Industries | Integral | Intel | Internationa Read employer surveys onPaper Company | Interpublic Group of Companies | Intuit | Irwin Financial | J. WalteThompson | J.C. Penney | J.P. Morgan Chase | Janney Montgomery Scott | JanuCapital | John Hancock Financial | Johnson & Johnson | Johnson Controls | KLA-Tenco THOUSANDS of top employers.Corporation | Kaiser Foundation Health Plan | Keane | Kellogg Company | KetchumKimberly-Clark Corporation | King & Spalding | Kinkos | Kraft Foods | Kroger | KurSalmon Associates | L.E.K. Consulting | Latham & Watkins | Lazard | Lehman BrothersLockheed Martin | Logica | Lowes Companies | Lucent Technologies | MBI | MBNAManpower | Marakon Associates | Marathon Oil | Marriott | Mars & Company | McCannErickson | McDermott, Will & Emery | McGraw-Hill | McKesson | McKinsey & Compan Merck & Co. | Merrill Lynch | Metropolitan Life | Micron Technology | Microsoft | MilleBrewing | Monitor Group | Monsanto | Morgan Stanley | Motorola | NBC | Nestle | NeweRubbermaid | Nortel Networks | Northrop Grumman | Northwestern Mutual FinanciaNetwork | Novell | OMelveny & Myers | Ogilvy & Mather | Oracle | Orrick, Herrington &Sutcliffe | PA Consulting | PNC Financial Services | PPG Industries | PRTM | PacifiCar Go to www.vault.comHealth Systems | PeopleSoft | PepsiCo | Pfizer | Pharmacia | Pillsbury Winthrop | PitneBowes | Preston Gates & Ellis | PricewaterhouseCoopers | Principal Financial GroupProcter & Gamble Company | Proskauer Rose | Prudential Financial | PrudentiaSecurities | Putnam Investments | Qwest Communications | R.R. Donnelley & Sons
  15. 15. Vault Guide to Finance Interviews The Financial Services Industry The Finance Interview: An Overview Investment banking and other finance positions are among the most stressful and demanding positions on the planet and interviews in finance often test an applicants tolerance for such an environment. To test an applicants stamina, interviews in finance traditionally involve three or four rounds at a minimum, and each round may have up to six interviews, with the number of interviews generally increasing in each round. To test an applicants ability to handle stress, interviewers may adopt aversive or stressful interviewing tactics. Insiders say that occasionally a bank or finance interviewer will go so far as to use techniques from rapid-fire quantitative questions such as “How many planes are currently flying over the United States right now?” to confrontational questions such as, “Why should I give you this job? Your resume doesnt fit our profile.” Firms may ask you specific and detailed questions about your grades in college or business school, even if your school policy prohibits such questions. At other firms, interview rounds may be interspersed with seemingly casual and friendly dinners. Don’t let down your guard! While these dinners are a good opportunity to meet your prospective co-workers, your seemingly genial hosts are scrutinizing you as well. (Read: Don’t drink too much.) There are generally two parts to the finance hiring process: the “fit part” and the “technical part.” The “fit part” is where the hiring firm deciphers whether or not you fit into their group’s culture. The “technical part” is where the interviewer judges your analytical and technical skills. If you don’t know the basic concepts of finance and accounting, your interviewers will believe (rightly) that you are either 1) not interested in the position or 2) not competent enough to handle the job. While a good deal of this book is devoted to helping you ace the technical part of finance interviews, it is arguably more important that you nail the fit interview, proving that you are someone the people in the group would like to work with. As you go through recruiting in finance interviews, understand that you compete with yourself. Most firms are flexible enough to hire people that are a good fit. The fit interview They call it the O’Hare airport test, the Atlanta airport test, or the whatever- city-you-happen-to-be-applying-in airport test. They also call it the fit interview or the behavioral interview. It means: “Could you stand to be stranded in an airport for eight hours with this person?” CAREER6 LIBRARY © 2005 Vault Inc.
  16. 16. Vault Guide to Finance Interviews The Financial Services Industry Generally, while your performance in the fit interview partly depends – as the airport test suggests – on your personality fit, it also depends on your “career fit,” or your ability to portray yourself as a good fit as an investment banker, asset manager, and so on. In other words, interviewers will try to figure out what your attitude towards work is like, how interested you are in a career in the industry, and how interested you are in the job for which you are applying. I’m a hard worker As a general rule, you should emphasize how hard you have worked in the past, giving evidence of your ability to take on a lot of work and pain. You don’t have to make things up or pretend that there’s nothing you’d want more than to work 100-hour weeks. In fact, interviewers are sure to see through such blatant lying. Says one I-banking interviewer, “If somebody acted too enthusiastic about the hours, that’d be weird.” If you ask investment bankers and others in finance what they dislike most about their jobs, they will most likely talk about the long hours. Be honest about this unpleasant part of the job, and convince your interviewer that you can handle it well. For example, if you were in crew and had to wake up at five every morning in the freezing cold, by all means, talk about it. If you put yourself through school by working two jobs, mention that, too. And if no experience applies, at least acknowledge the hours as a necessary part of a career path you are choosing. Got safe hands? As with all job interviews, finance interviews will be focused on figuring out whether you can handle the responsibility required of the position, understandable considering that in many cases with finance positions, that responsibility may mean making decisions with millions or billions of dollars. An interviewer will try and figure out if you’ve got safe hands and won’t be dropping the ball. “This is a critical I-banking concept,” says one banker about safe hands. “The idea is: ‘Can I give this person this analysis to do and feel comfortable that they will execute it promptly and correctly?’ The people with safe hands are the ones who advance in the company. They are not necessarily the hardest workers but they are the most competent.” Make sure you bring up examples of taking responsibility and getting complex, detail-oriented jobs done right.Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 7
  17. 17. Vault Guide to Finance Interviews The Financial Services Industry A mind to pick things apart The world of finance involves a lot of number crunching and analytical ability. And while you don’t have to be a world-class mathematician, you do have to have an analytic mind if you are going to succeed. Explains one insider at a numbers-heavy Wall Street firm, “you can’t be any old English major. You’ve got to have a really logical, mathematical head.” Make sure you have examples of your problem-solving and analytic strengths, particularly those involving quantitative analysis. T-E-A-M! Go team! Teamwork is a popular buzzword for employers of all industries. Every finance position (except, perhaps, for research) requires that an employee work closely with others – whether in investment banking deal teams or in cross-fuctional corporate teams such as the finance officials working with marketers at a large corporation. Interviewers will ask questions to make sure that you have experience and have excelled in team situations. Sure, you can break out those glory days stories about the winning touchdown pass, but hopefully there are more poignant situations which can also help describe your teamwork ability – previous work experience, volunteer activities, or school work in teams, to name a few. Preparing for finance interviews When you review career options, don’t discount the amount of time it takes to prepare for finance interviews. First of all, you should evaluate whether you actually want to be in finance. In short, you should know what you’re getting into. Not only should you know this for your own sake (this is your future, after all), but your interviewers want to know that you understand the position and industry. You should use the opportunity of non-evaluative settings (i.e., not an interview) to ascertain if finance is for you. These are questions to which we strongly suggest you have answers to before interviewing. Make a point to attend recruiting presentations by firms. Informational interviews with alumni and (for those in business school) second-years are also good ways to get answers to some of your questions. As for written materials, you can start with general business publications like The Wall Street Journal, The Economist, BusinessWeek, and the Financial Times. From there, you can move on to trade publications that will give more industry-specific news and analysis. American Banker, CAREER8 LIBRARY © 2005 Vault Inc.
  18. 18. Vault Guide to Finance Interviews The Financial Services Industry Institutional Investor, Investment Dealers’ Digest and The Daily Deal are some examples. Your interaction with alumni can have direct results. The results can be good if you prepare properly before contacting them, are sufficiently informed, ask good and sincere questions, and show proper respect. You can also assure yourself a ding if you don’t handle a meeting or phone conversation correctly. Here are some questions about finance positions you should ask before you have your first interview: • What is a typical day like? • What are the hours in the industry really like? Are they 100 hours every week or every other week? Is it the same for every firm? • How do people cope with the lifestyle issues in the industry? • What kind of money do people make in the industry? • What are the things I-bankers (or commercial bankers, venture capitalists, etc.) like about their jobs? What would they like to change? • What is the future of the industry for the next few years? How will the industry change? How will the margins change? The return on equity? • What is the career track in the industry? What skills are required at what stage? • What is so exciting about this job? • What is the culture of an I-banking firm as compared to a Fortune 500 company? Compared to a startup? • What are the exit opportunities after 10 years in the industry? After two years? Research individual firms Once you’ve answered questions about the industry, you should begin to narrow your research to specific firms – both to know which firms to target, and to be knowledgeable for your interviews. Good sources for research are easily accessible publications like The Wall Street Journal, BusinessWeek and Fortune. If you have the resources (perhaps at a school library), you can also read through recent issues of trade publications like Investment Dealers’ Digest. And of course, to get the inside scoop on culture, pay, and hiring at top firms, read the company profiles on, as well asVisit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 9
  19. 19. Vault Guide to Finance Interviews The Financial Services Industry guides like The Vault Guide to the Top 50 Banking Employers and The Vault Guide to the Top Financial Services Firms. Insiders at business school who have gone through the recruiting process suggest that you form research and interview practice teams. There is a lot of material to cover, and it is not possible to do it all by yourself. Form teams for researching industries and firms. Later, you can use the same teams to practice interviews. If you are an undergraduate, you should try to see if your school has an investment banking or finance club. If you are in business school, your school will undoubtedly have such a club, or you may want to team up with other students who are looking into finance careers. Teams of four to six work quite well for this research process. Practice your interviews As you read this guide, you should prepare answers to common questions given at finance interviews – whether they be fit questions, technical questions, or brainteasers. While this may be easiest for technical questions and brainteasers (after all, we can help you to nail those questions with the right answers), it is also important to prepare for fit questions even if there are no right or wrong answers. We can steer you onto the right path with these questions, but you’ll need to fill in the blanks. What’s the hardest thing you’ve ever had to do? Can you give me an example of a time when you came up with a creative solution? You don’t want to be cursing yourself after an interview, thinking about what you should have said, or examples you could have brought up. One of the best ways to prepare answers to these questions is to use mock/practice interviews. You can practice by role-playing with your friends and classmates, or by taking advantage of interview training offered by your school. Most MBA career centers, and many undergraduate career centers, offer students the opportunity to perform mock interviews, which are normally videotaped. These practice sessions are conducted either by professional career counselors or by second-year students. The mock interviewees are given the videotape of their critique to watch at home (again and again). Students may choose what kind of interview they’d like to receive: finance, consulting, etc. What mistakes are commonly unearthed by the videotaped interview? One business school career counselor says that he finds that “most MBAs don’t have their story down. They can’t elaborate on why they came to business school, and why they want to work in the industry.” The best candidates are able to describe their background and career history, and make a pitch about CAREER10 LIBRARY © 2005 Vault Inc.
  20. 20. Vault Guide to Finance Interviews The Financial Services Industry why they are interested in a firm, all in a minute or less, career counselors say. Another problem is that many students apparently “can’t elaborate their strengths. They have them, but can’t sell them. They are too modest.” While there’s no use demurring when explicating your good points, career center professionals warn that “there is also a danger of tooting your horn too much” – so make sure you’re not making any claims for competency you can’t back up with relevant experience. To take full advantage of their mock interviews, career counselors say, you should take them as seriously as possible. Dress professionally “to get into the interviewing mindset.” Afterwards, the interviewer will go over the session, assessing your strengths and weaknesses. It’s a good idea to take notes on this feedback. Mock interviewers also coach students on appropriate answers. “For example,” explains one mock interviewer, “many candidates are asked to name their top three weaknesses. Answering with your actual weaknesses is not a good idea. So when I identify a student’s weaker point – maybe they are weak on real teamwork experience – we strategize on an appropriate answer. It’s better to say something like ‘I wouldn’t call them weaknesses, but there are three areas in which I still have room to grow,’ and then choose three areas that are not deal-breakers.” Do interviewers thus end up hearing the same canned answers over and over again? “I do hear from some interviewers at certain schools – not mine! – that they do hear identical answers to certain questions,” says one insider. “My advice to students is to always put answers into their own words.” Prepare questions Finally, don’t forget that finance interviewers often ask candidates whether they have any questions. Don’t get caught looking like a job applicant who hasn’t done research and is not curious about the opportunities. Read about the firms, read about the industries, and prepare some intelligent questions. Also, remember that, when in doubt, you can allow the interviewers to talk about themselves with questions like, “Tell me about your career path” and “Describe your typical day-to-day responsibilities.”Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 11
  21. 21. Vault Guide to Finance Interviews The Financial Services Industry Questions 1. Why do you want to do investment banking/investment management/ whatever career you plan to pursue? This is a question you are almost guaranteed to receive. First and foremost, you must emphasize that you know what the finance department in which you are interviewing does. Talk to as many people in the industry before the interview to get a good idea of the job function’s day-to-day tasks as well as the general description of the work a person in that job is asked to perform. Then, when asked the question, you need not state that you’ve yearned to be in finance your life, but you should illustrate succinctly that you know the job functions of the position for which you are interviewing, that you enjoy performing these functions, and that you have developed the core skills required (i.e., analytical ability, good communication skills, and, of course, a strong work ethic and willingness to put in the hours to do the job). 2. What exactly do investment bankers (or investment managers, etc.) do? Don’t laugh. You’d be astonished at how many people go to interview with Goldman Sachs or Fidelity Investments without having a clear idea of what they’ll be doing if they actually get the job. You are very likely to receive this question if you are a career-changer or if you have a non-financial background. You’d better know the basics of your industry – for example, that investment bankers raise capital for companies in the public or private marketplace or that investment managers manage money for individuals and institutions. 3. Here’s a whiteboard. Stand in front of it and present a chapter from your favorite finance textbook. You have five minutes. May we suggest not selecting the introduction? The point of this question is twofold. First of all, the interviewers want to test your ability to explain complicated financial matters in lucid terms. Secondly, they want to test your on-the-spot presentation skills. Practice with a friend – even with your professor, if you can – until you’re comfortable presenting this material. 4. Walk me through your resume. Again, highlight those activities and previous positions that are most applicable to the core finance skills. Also talk about the things you are proud CAREER12 LIBRARY © 2005 Vault Inc.
  22. 22. Vault Guide to Finance Interviews The Financial Services Industry of and that set you apart. Finally, illustrate that your educational and career moves follow a logical sequence. 5. Let me give you a situation: It is Friday afternoon. Tomorrow morning you have to catch a flight to Boston for your best friend’s marriage, and you are in the wedding. You have informed your deal team well in advance and they know that you will be gone. Just when you are about to leave, you find out that a client wants to meet with the banking team tomorrow. What will you do? One of the big assets you bring to a finance position, especially those with investment banks, is your attitude towards work. This is a rather tricky question, but use this to express the fact that you understand the hardships that an I-banking career would involve, and that you have endured such sacrifice situations previously. 6. Say you are supposed to meet your girlfriend for dinner but the MD asks you to stay late. What do you do? Can you give me an example of a similar situation you have faced before? Another attitude question. Be prepared. 7. Why should we hire you? When answering an open-ended question like this, try to make them insightful and entertaining like you did for your school applications. Again, this question begs you to illustrate that you understand the position for which you are interviewing and that you are hardworking, analytical, and team-oriented. Prepare examples and as you do, think of them as if they were speeches. What would your stories and anecdotes be? Would they be exciting? Funny? Insightful? Absorbing? Something that the audience would remember for a long time? Unique? 8. Why did you decide to do an MBA? If you are an MBA student looking for a finance position, you are probably going to get this question. If you came from a finance background, you can talk about how you thought you would add to your skill set by going to business school, and how that expectation has panned out. If you did not, simply answer the question as honestly as you can. As an aside, it is perfectly appropriate to respond that you are getting an MBA as a means for changing careers.Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 13
  23. 23. Vault Guide to Finance Interviews The Financial Services Industry 9. What types of activities did you pursue while in college? While it may be all good and well to talk about the soup kitchen, remember that you’re interviewing for intense, stressful positions. Says one interviewer, “We love to see people who worked part-time, went to all six of their classes, got As and don’t seem to need sleep. Frankly, banks like people in debt who will kill themselves for the big bonus. I believe ‘hungry’ people are highly valued in the interview process.” 10. Why are you applying to this firm? Do your research and find out what each firm prides itself on, whether it be international presence, team-orientation or social environment. Get ready to talk about the industry and the firm specifically. For some firms (smaller, specialized I-banks like Lazard, for example), this is an especially important question. Says one insider at a boutique firm, “You definitely want to have someone who knows what they’re getting into. I don’t think its advisable to say I’m looking at all the bulge-bracket firms – plus [yours]. You want to see people who are very focused.” And even at those big firms that all seem the same, your interviewer will be impressed and flattered if you can talk about how his or her firm is different and why that interests you. 11. Give me an example of a project that you’ve done that involved heavy analytical thinking. Candidates without a financial background should have an answer prepared for this question that describes a work or school project, focusing on the part that required a lot of number crunching. 12. If you were the CEO of our bank, what three things would change? An interesting question. This question assumes, first of all, that you’ve done enough research on your potential future employer to answer this question. Telling your interviewers that you’d open an office in Shanghai may be a good answer – but not if the firm already has an office in that city. Be prepared to defend your answers. Avoid being too negative – “I’d fire the CFO” is a bad answer if one of your interviewers works with him. 13. What is your favorite web site? Up to you. If you own stock, it’s fine to choose a site like Ameritrade. You could choose Vault, for the research on your favorite firms. If you want to impress them with your business savvy, you could simply choose a web site CAREER14 LIBRARY © 2005 Vault Inc.
  24. 24. Vault Guide to Finance Interviews The Financial Services Industry that you think is run especially well, like eBay. Just be prepared to back up your answer with specific information. 14. Tell me about the stock price of a company in your prior line of work. Make sure you’re conversant with how your previous employers (or competitors) are doing before you interview. 15. Give me an example of a time you worked as part of a team. You’re sure to get this one. Draw on experiences from previous work experience, from volunteer activities, and from any other situation in which you worked with others toward a common goal. Highlight your strengths as a team member: empathy, collaboration and consensus-building are good themes to emphasize. 16. What is the most striking thing you’ve read recently in The Wall Street Journal? A variation of this question is: “What publications do you read regularly?” With these questions, your interviews want to see how well read you are, how interested you are in finance, and how well you can describe any of the recent burning financial issues. Read the Journal regularly, especially when it is close to the interview time. We suggest starting with 45 minutes a day and gradually bringing that down as you become more efficient in your information-gathering. 17. Describe a project you have worked on that you enjoyed. Yet another opportunity to show that you are a hardworking, responsible, analytical team player. 18. Let’s say I give you this summer job/full-time job today. Now let’s move to the future and say that at the end of the summer, you find out that you did not get a full-time offer, or that six months into the job you are fired. Give me three reasons why this could happen, and what you can do to prevent this. This is a twist on the “what are your biggest weaknesses” question, made specifically more stressful for the finance interview. Don’t lose your cool, and have answers prepared.Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 15
  25. 25. Vault Guide to Finance Interviews The Financial Services Industry 19. Think of a person you feel knows you very well both professionally and socially. If I were to call this person and ask him to describe you, what would he say? Yet another version of the strengths and weaknesses question. 20. What motivates you? Think through this one. First of all, you should indicate that you are highly motivated. Second, remember the profile that finance interviews are generally looking for. Appropriate answers include financial security, problem-solving, deadlines, and productivity. Again, be prepared to give examples. 21. Can you give me an example of an experience of failure? You should have an answer prepared for this question. Be modest and admit that you have experienced setbacks. Also, focus on how you bounced back from the setback and what you learned from the experience. 22. You don’t seem like you are a very driven person. How will you be able to handle a job in banking? A stress question that can easily hit you at the tail end of a long and tiring interview process. After meeting with more than a dozen people in a day, it may be very easy to appear worn out, which is precisely what you must avoid – you must convince your interviewer that you don’t wear out easily by displaying good energy. Come up with good examples of a time when you were totally driven despite fatiguing circumstances. 23. Tell me about an accomplishment that you are proud of. This is your chance to shine. Remember: team-oriented, analytical, hardworking, dependable. 24. What was your favorite course in school? Your least favorite? Why? What were your grades in each? Have a few choices ready and be prepared to justify them. Don’t say that you didn’t like a class because it was “too hard” or “had too much math” or even that “the professor was unreasonable” (because your interviewer may wonder if you’ll think your boss unreasonable as well). Remember that your interviewer most likely has your transcript in front of her, so don’t try to inflate your grades. CAREER16 LIBRARY © 2005 Vault Inc.
  26. 26. Vault Guide to Finance Interviews The Financial Services Industry 25. Tell me how you have modeled with equations in the past. If you’re an economics major, or if you’ve owned a business, you shouldn’t have a problem answering this question. Even if you’re a non-finance major, you should have at least one class or real-life example you can provide. If you’ve never done financial modeling, do at least one example before the interview or have someone walk you through the process. 26. Who have you talked to at our bank? This is actually a good sign – your interviewer may ask them for impressions of you. You should remember the names of any representatives who have attended campus career events. Hopefully, in your research you’ve connected with people at that firm. 27. Can you tell me about a time when you handled many things at the same time? In some finance positions, especially I-banking, multi-tasking is an important attribute. Think through your background and prepare for this question. 28. What would you like for me to tell you? Remember, you will be asked if you have any questions. Do your research and impress your interviewer with your knowledge and insight. However, don’t ask transparent questions that seem like you are only asking them because you have to. And, again, when in doubt, ask about their own personal experiences. 29. What is a hedge fund? This is obviously a popular question for those candidates interviewing for the increasingly popular and prestigious hedge fund positions. Surprisingly, many candidates have no feel for what distinguishes a hedge fund from other types of funds. A hedge fund is a private investment partnership which uses aggressive strategies unavailable to other types of funds, most popularly mutual funds. Hedge funds are required by law to have less than 100 investors, and liberally use such financial techniques and vehicles as short-selling, swaps, risk arbitrage and derivatives Since they are restricted by law to less than 100 investors, the minimum hedge-fund investment is typically $1 million. (For more information, get the Vault Career Guide to Hedge Funds.)Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 17
  27. 27. Decrease your T/NJ Ratio (Time to New Job)Use the Internet’s most targetedjob search tools for financeprofessionals.Vault Finance Job BoardThe most comprehensive and convenient job board for financeprofessionals. Target your search by area of finance, function,and experience level, and find the job openings that you want.No surfing required.VaultMatch Resume DatabaseVault takes match-making to the next level: post your resumeand customize your search by area of finance, experience andmore. We’ll match job listings with your interests and criteriaand e-mail them directly to your inbox.
  29. 29. Vault Guide to Finance Interviews Valuation Techniques How Much is it Worth? Imagine yourself as the CEO of a publicly traded company that makes widgets. You’ve had a highly successful business so far and want to sell the company to anyone interested in buying it. How do you know how much to sell it for? Likewise, consider the Bank of America acquisition of Fleet. How did B of A decide how much it should pay to buy Fleet? For starters, you should understand that the value of a company is equal to the value of its assets, and that Value of Assets = Debt + Equity or Assets = D + E If I buy a company, I buy its stock (equity) and assume its debt (bonds and loans). Buying a company’s equity means that I actually gain ownership of the company – if I buy 50 percent of a company’s equity, I own 50 percent of the company. Assuming a company’s debt means that I promise to pay the company’s lenders the amount owed by the previous owner. The value of debt is easy to calculate: the market value of debt is equal to the book value of debt. (Unless the debt trades and thus has a real “market value.” This information, however, is hard to come by, so it is safe to use the book value.) Figuring out the market value of equity is trickier, and that’s where valuation techniques come into play. The four most commonly used techniques are: 1. Discounted cash flow (DCF) analysis 2. Multiples method 3. Market valuation 4. Comparable transactions method Generally, before we can understand valuation, we need to understand accounting, the language upon which valuation is based. CAREER20 LIBRARY © 2005 Vault Inc.
  30. 30. Vault Guide to Finance Interviews Valuation TechniquesBasic Accounting Concepts Before we look at these valuation techniques, let’s take a look at basic accounting concepts that underpin valuation. MBAs interested in finance careers should definitely be comfortable with these concepts (and may find this overview to be very basic). Undergrads who have taken accounting classes should already be familiar with these concepts as well. Basic overview of financial statements There are four basic financial statements that provide the information you need to evaluate a company: • Balance Sheets • Income Statements • Statements of Cash Flows • Statements of Retained Earnings These four statements are provided in the annual reports (also referred to as “10Ks”) published by public companies. In addition, a company’s annual report is almost always accompanied by notes to the financial statements. These notes provide additional information about each line item of numbers provided in the four basic financial statements. The Balance Sheet The Balance Sheet presents the financial position of a company at a given point in time. It is comprised of three parts: Assets, Liabilities, and Shareholder’s Equity. Assets are the economic resources of a company. They are the resources that the company uses to operate its business and include Cash, Inventory, and Equipment. (Both financial statements and accounts in financial statements are capitalized.) A company normally obtains the resources it uses to operate its business by incurring debt, obtaining new investors, or through operating earnings. The Liabilities section of the Balance Sheet presents the debts of the company. Liabilities are the claims that creditors have on the company’s resources. The Equity section of the Balance Sheet presents the net worth of a company, which equals the assets that the company owns less the debts it owes to creditors. In other words, equity is comprised of the claims that investors have on the company’s resources after debt is paid off. Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 21
  31. 31. Vault Guide to Finance Interviews Valuation Techniques The most important equation to remember is that Assets (A) = Liabilities (L) + Shareholder’s Equity (SE) The structure of the Balance Sheet is based on that equation. This example uses the basic format of a Balance Sheet: Media Entertainment, Inc Balance Sheet (December 31, 2005) Assets Liabilities Cash 203,000 Accounts Payable 7,000 Accounts Receivable 26,000 Building 19,000 Equity Common Stock 10,000 Retained Earnings 231,000 Total Assets 248,000 Total Liabilities & Equity 248,000 With respect to the right side of the balance sheet, because companies can obtain resources from both investors and creditors, they must distinguish between the two. Companies incur debt to obtain the economic resources necessary to operate their businesses and promise to pay the debt back over a specified period of time. This promise to pay is based on a fixed payment schedule and is not based upon the operating performance of the company. Companies also seek new investors to obtain economic resources. However, they don’t promise to pay investors back a specified amount over a specified period of time. Instead, companies forecast for a return on their investment that is often contingent upon assumptions the company or investor makes about the level of operating performance. Since an equity holder’s investment is not guaranteed, it is more risky in nature than a loan made by a creditor. If a company performs well, the upside to investors is higher. The promise-to-pay element makes loans made by creditors a Liability and, as an accountant would say, more “senior” than equity holdings, as it is paid back before distributions to equity-holders are made. To summarize, the Balance Sheet represents the economic resources of a business. One side includes assets, the other includes liabilites (debt) and shareholder’s equity, and Assets = L+E. On the liability side, debts owed to creditors are more senior than the investments of equity holders and are CAREER22 LIBRARY © 2005 Vault Inc.
  32. 32. Vault Guide to Finance Interviews Valuation Techniques classified as Liabilities, while equity investments are accounted for in the Equity section of the Balance Sheet. The Income Statement We have discussed two of the three ways in which a company normally obtains the economic resources necessary to operate its business: incurring debt and seeking new investors. A third way in which a company can obtain resources is through its own operations. The Income Statement presents the results of operations of a business over a specified period of time (e.g., one year, one quarter, one month) and is composed of Revenues, Expenses and Net Income. Revenue: Revenue is a source of income that normally arises from the sale of goods or services and is recorded when it is earned. For example, when a retailer of roller blades makes a sale, the sale would be considered revenue. Expenses: Expenses are the costs incurred by a business over a specified period of time to generate the revenues earned during that same period of time. For example, in order for a manufacturing company to sell a product, it must buy the materials it needs to make the product. In addition, that same company must pay people to both make and sell the product. The company must also pay salaries to the individuals who operate the business. These are all types of expenses that a company can incur during the normal operations of the business. When a company incurs an expense outside of its normal operations, it is considered a loss. Losses are expenses incurred as a result of one-time or incidental transactions. The destruction of office equipment in a fire, for example, would be a loss. Assets and expenses Incurring expenses and acquiring assets both involve the use of economic resources (i.e., cash or debt). So, when is a purchase considered an asset and when is it considered an expense? Assets vs. expenses: A purchase is considered an asset if it provides future economic benefit to the company, while expenses only relate to the current period. For example, monthly salaries paid to employees for services they already provided to the company would be considered expenses. On the other hand, the purchase of a piece of manufacturing equipment would be classified as an asset, as it will probably be used to manufacture a product for more than one accounting period.Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 23
  33. 33. Vault Guide to Finance Interviews Valuation Techniques Net income: The Revenue a company earns, less its Expenses over a specified period of time, equals its Net Income. A positive Net Income number indicates a profit, while a negative Net Income number indicates that a company suffered a loss (called a “net loss”). Here is an example of an Income Statement: Media Entertainment, Inc Income Statement (For the year ended December 31, 2005) Revenues Services Billed 100,000 Expenses Salaries and Wages (33,000) Rent Expense (17,000) Utilities Expense (7,000) (57,000) Net Income 43,000 To summarize, the Income Statement measures the success of a company’s operations; it provides investors and creditors with information needed to determine the enterprise’s profitability and creditworthiness. A company has earned net income when its total revenues exceed its total expenses. A company has a net loss when total expenses exceed total revenues. The Statement of Retained Earnings Retained earnings is the amount of profit a company invests in itself (i.e., profit that is not used to pay back debt or distributed to shareholders as a dividend). The Statement of Retained Earnings is a reconciliation of the Retained Earnings account from the beginning to the end of the year. When a company announces income or declares dividends, this information is reflected in the Statement of Retained Earnings. Net income increases the Retained Earnings account. Net losses and dividend payments decrease Retained Earnings. CAREER24 LIBRARY © 2005 Vault Inc.
  34. 34. Vault Guide to Finance Interviews Valuation Techniques Here is an example of a basic Statement of Retained Earnings: Media Entertainment, Inc Statement of Retained Earnings (For the year ended December 31, 2005) Retained Earnings, January 1, 2005 $200,000 Plus: Net income for the year 43,000 243,000 Less: Dividends declared (12,000) Retained Earnings, December 31, 2005 $ 231,000 As you can probably tell by looking at this example, the Statement of Retained Earnings doesn’t provide any new information not already reflected in other financial statements. But it does provide additional information about what management is doing with the company’s earnings. Management may be reinvesting the company’s net income into the business by retaining part or all of its earnings, distributing its current income to shareholders, or distributing current and accumulated income to shareholders. (Investors can use this information to align their investment strategy with the strategy of a company’s management. An investor interested in growth and returns on capital may be more inclined to invest in a company that reinvests its resources into the company for the purpose of generating additional resources. Conversely, an investor interested in receiving current income is more inclined to invest in a company that pays quarterly dividend distributions to shareholders.) The Statement of Cash Flows Remember that the Income Statement provides information about the economic resources involved in the operation of a company. However, the Income Statement does not provide information about the actual source and use of cash generated during its operations. That’s because obtaining and using economic resources doesn’t always involve cash. For example, let’s say you went shopping and bought a new mountain bike on your credit card in July – but didn’t pay the bill until August. Although the store did not receive cash in July, the sale would still be considered July revenue. TheVisit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 25
  35. 35. Vault Guide to Finance Interviews Valuation Techniques Statement of Cash Flows presents a detailed summary of all of the cash inflows and outflows during the period and is divided into three sections based on three types of activity: • Cash flows from operating activities: Includes the cash effects of transactions involved in calculating net income. • Cash flows from investing activities: Basically, cash from non-operating activities or activities outside the normal scope of business. This involves items classified as assets in the Balance Sheet and includes the purchase and sale of equipment and investments. • Cash flows from financing activities: Involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as issuing payment of debt or equity. This example shows the basic format of the Statement of Cash Flows: Media Entertainment, Inc Statement of Cash Flows (For the year ended December 31, 2005) Cash flows provided from operating activities Net Income 33,000 Depreciation Expense 10,000 Increase in Accounts Receivable (26,000) Increase in Accounts Payable 7,000 (19,000) Net cash provided by operating activities 24,000 Cash flows provided from investing activities Purchase of Building (19,000) Sale of Long-Term Investment 35,000 Net cash provided by investing activities 16,000 Cash flows provided from financing activities Payment of Dividends (12,000) Issuance of Common Stock 10,000 Net cash provided by financing activities (2,000) Net increase (decrease) in cash 38,000 Cash at the beginning of the year 165,000 Cash at the end of the year 203,000 CAREER26 LIBRARY © 2005 Vault Inc.
  36. 36. Vault Guide to Finance Interviews Valuation Techniques As you can tell be looking at the above example, the Statement of Cash Flows gets its information from all three of the other financial statements: • Net income from the Income Statement is shown in the section “cash flows from operating activities.” • Dividends from the Statement of Retained Earnings is shown in the section “cash flows from financing activities.” • Investments, Accounts Payable, and other asset and liability accounts from the Balance Sheet are shown in all three sections.Market Valuation Now let’s look at the major techniques of valuation. We’ll begin with market valuation, as it is the simplest way to value a publicly traded firm. A publicly traded firm is one that is registered on a stock exchange (like the New York Stock Exchange or Nasdaq). The company’s stock can be bought and sold on that exchange. Most companies we are familiar with, such as The Coca-Cola Company, IBM, and General Motors, are publicly traded. Every publicly traded company is required to publish an annual report, which includes financial figures such as annual revenues, income, and expenses. The 10Ks (Annual Financials) and 10Qs (Quarterly Financials) for publicly traded firms are available online through the SEC Edgar database, The value of a publicly traded firm is easy to calculate. All you need to do is find the company’s stock price (the price of a single share), multiply it by the number of shares outstanding, and you have the equity market value of the company. (This is also known as market capitalization or “market cap”). The market price of a single share of stock is readily available from publications like The Wall Street Journal and from various quote services available on the Internet; the number of shares outstanding can be obtained from the cover of the most recent 10-K or 10-Q of the company, or from web sites such as Yahoo! Finance, Hoover’s Online, and Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 27
  37. 37. Vault Guide to Finance Interviews Valuation Techniques Example: Company A stock price $60/share No. of shares outstanding 200 million ___________________________ Equity Market Value (market cap) = $60 x 200 million = $12 billion Once you determine the market value of a firm, you need to figure out either the discount or premium that it would sell for if the company were put on the market. When a company sells for a discount it is selling for a value lower than the market value; when it sells for a premium, it is selling for a value greater than the market value. Whether a company sells at a premium or a discount depends on those supply and demand forces you learned about in Econ 101. Typically, if someone wants to acquire a firm, it will sell for a price above the market value of the firm. This is referred to as an acquisition premium. If the acquisition is a hostile takeover, or if there is an auction, the premiums are pushed even higher. The premiums are generally decided by the perception of the synergies resulting from the purchase or merger. (See chapter on M&A.) Discounted Cash Flow (DCF) The DCF analysis is the most thorough way to value a company, and second- year MBAs should expect to be tested on their ability to do a DCF in a finance interview. There are two ways to value a company using the DCF approach: • Adjusted Present Value (APV) method • Weighted Average Cost of Capital (WACC) method Both methods require calculation of a company’s free cash flows (FCF) as well as the net present value (NPV) of these FCFs. Before we look at these methods, we’ll examine a few underlying concepts: net present value, the Capital Asset Pricing Model (CAPM), free cash flows, and terminal year value. Net Present Value What do we mean when we talk about net present value? We’ll explain this important concept with a simple example. Let’s say you had an arrangement CAREER28 LIBRARY © 2005 Vault Inc.
  38. 38. Vault Guide to Finance Interviews Valuation Techniques under which you were set to receive $20 from a friend one year from now. Now let’s say for some reason that you decide you don’t want to wait for a year and would rather have the money today. How much should you be willing to accept today? More than $20, $20, or less than $20? In general, a dollar today is worth more than a dollar tomorrow for two simple reasons. First, a dollar today can be invested at a risk-free interest rate (think savings account or U.S. government bonds), and can earn a return. A dollar tomorrow is worth less because it has missed out on the interest you would have earned on that dollar had you invested it today. Second, inflation diminishes the buying power of future money. A discount rate is the rate you choose to discount the future value of your money. A discount rate can be understood as the expected return from a project that matches the risk profile of the project in which youd invest your $20. Note: The discount rate is different than the opportunity cost of the money. Opportunity cost is a measure of the opportunity lost. Discount rate is a measure of the risk. These are two separate concepts. To express the relationship between the present value and future value, we use the following formula: Future Value Present Value = (1 + rd ) n Here, “rd” is the discount rate, and “n” is the number of years in the future. The method of calculating the discount rate is different depending on the method of valuation used (i.e., APV method vs. WACC method). Although the discount rate varies, the concept of NPV, or net present value, is the same. Let’s say a series of cash flows is expressed as the following:Year 1 2 3 4 5 6 7 8Free Cash FCF1 FCF2 FCF3 FCF4 FCF5 FCF6 FCF7 FCF8Flows Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 29
  39. 39. Vault Guide to Finance Interviews Valuation Techniques Net present value (NPV) in Year 0 of future cash flows is calculated with the following formula: FCF1 FCF2 FCF3 FCF8 NPV = 1 + 2 + 3 +...+ 8 (1 + rd) (1 + rd) (1 + rd) (1 + rd) or ( ) n FCFi NPV = ∑ (1 + rd) i i=1 Here again, rd is the discount rate, which is calculated differently depending on whether you use APV or WACC (to be explained later). Capital Asset Pricing Model (CAPM) In order to find the appropriate discount rate used to discount the company’s cash flows, you use the Capital Asset Pricing Model, or (CAPM). This is a model used to calculate the expected return on your investment, also referred to as expected return on equity. It is a linear model with one independent variable, Beta. Beta represents relative volatility of the given investment with respect to the market. For example, if the Beta of an investment is 1, the returns on the investment (stock/bond/portfolio) vary identically with the market returns. A Beta less than 1, like 0.5, means the investment is less volatile than the market. So if the Dow Jones Industrial Average goes up or down 20 percent the next day, a less volatile stock (i.e., Beta < 1) would be expected to go up or down 10 percent. A Beta of greater than 1, like 1.5, means the investment is more volatile than the market. A company in a volatile industry (think Internet company) would be expected to have a Beta greater than 1. A company whose value does not vary much, like an electric utility, would be expected to have a Beta under 1. Mathematically, CAPM is calculated as re = rf + ß (rm - rf) CAREER30 LIBRARY © 2005 Vault Inc.
  40. 40. Vault Guide to Finance Interviews Valuation Techniques Here: re = Discount rate for an all-equity firm rf = Risk-free rate (The Treasury bill rate for the period over which the cash projections are being considered. For example, if we are considering a 10-year period, then the risk-free rate is the rate for the 10-year U.S. Treasury note.) rm = Market return rm - rf = Excess market return (This is the excess annual return of the stock market over a U.S. Treasury bond over a long period of time. This is usually assumed to be 7 percent for the U.S. Market.) ß = Equity Beta Equity Beta is given in various sources like Value Line or Internet sites like Yahoo! Finance. If the firm you are valuing is not publicly traded, then you need to find a firm with a similar Balance Sheet and Income Statement that is publicly traded. (When calculating CAPM you should be careful to use the “equity Beta” value, and not “assets Beta.”) If you have information for Beta assets rather than Beta equity, you can derive Beta equity using the following relationship: (E) (D) ßA = (ßE) + (1 - t) (ßD) (D+E) (D+E) Here: D= Market value of debt (usually the book value of debt) E = Market value of equity (the number of shares outstanding x share price) (Also known as “market cap.”) ßD = Beta debt (usually one can assume this to be equal to 0) t = Corporate taxes, (usually assumed to be 35%) Therefore:Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 31
  41. 41. Vault Guide to Finance Interviews Valuation Techniques (D + E) ßE = ßA (E) Free cash flows To capture the characteristics of an all-equity firm we recalculate a company’s cash flows as if the firm had no debt. The free cash flow (FCF) of an all-equity firm in year (i) can be calculated as: FCFi = Earnings Before Interest and Taxes x (1 - t) + Depreciation & Amortization - Capital Expenditure (“CapEx”) - Net increase in working capital (or + net decrease in working capital) + Other relevant cash flows for an all equity firm Here: Earnings Before Interest and Taxes (or EBIT) can be obtained from the Income Statement (see section on major accounting concepts). t = Corporate tax rate, usually assumed to be 35%. Depreciation & Amortization of a firm can be obtained from the firm’s Balance Sheet (see section on major accounting concepts). Capital Expenditure and Net increase in working capital can be obtained from the Statement of Cash Flows. Other relevant cash flows for an all-equity firm would be items like asset sale proceeds (selling a major piece of real estate, for example) or the use of tax loss carry-forwards or tax credits. While all of these items can be found in the firm’s financial statements for historical periods, the free cash flow used for DCF analysis is expected future free cash flow. Bankers will typically construct projections, using a combination of guidelines from the company and a derivation of reasonable estimates using their own assumptions. While historical financial CAREER32 LIBRARY © 2005 Vault Inc.
  42. 42. Vault Guide to Finance Interviews Valuation Techniques statements are helpful in constructing projections, DCF analysis can only be done with future cash flow projections. Terminal year calculation The terminal year represents the year (usually 10 years in the future) when the growth of the company is considered stabilized. In other words... The cash flows of the first 10 years are determined by company management or a financial analyst, based on predictions and forecasts of what will happen. Then, a terminal year value needs to be calculated assuming that after year 10 the cash flows of the company keep growing at a constant “g.” Values of “g” are typically not as high as the first 10 years of growth, which are considered unstabilized growth periods. Instead, “g” represents the amount the company can feasibly grow forever once it has stabilized (after 10 years). The value of the terminal year cash flows (that is, the value in year 10) is given by: FCF10 (1 + g) TY FCF = (rd - g) The present value of the terminal year cash flows (that is, the value today) is given by: TY FCF PV (TY FCF) = 10 (1 + rd) or FCF10 (1 + g) PV (TY FCF) = 10 (1 + rd) (rd - g) Adding it up Adding the discounted value of the first 10 year FCFs, and the terminal year FCFs (CFs after year 10 into perpetuity) gives us the value of the company under the DCF analysis.Visit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 33
  43. 43. Vault Guide to Finance Interviews Valuation Techniques Calculating discount rates Remember when we said that there are several ways of calculating discount rates? We’ll now look at the two most popular methods of discounted cash flow (DCF) analysis tested in finance interviews: the WACC (Weighted Average Cost of Capital) and APV (Adjusted Present Value). The key difference between the two methods is the way in which the discount rate is calculated. For WACC, we calculate the discount rate for leveraged equity (reL) using the capital asset pricing model (CAPM); for APV, we calculate the discount rate for an all-equity firm (reU). WACC For WACC, the discount rate is calculated with the following formula: (E) (D) rdWACC = (reL) + (1 - t)(rD) (D + E) (D + E) Here: D = Market value of debt E = Market value of equity rD = Discount rate for debt = Average interest rate on long-term debt reL = Discount rate for (leveraged) equity (calculated using the CAPM) Note: The terms (E)/(D + E) and (D)/(D + E) represent the “target” equity and debt ratios (also referred to as the equity-to-debt and debt-to-equity ratios). CAPM: reL = rf + ßL (rm - rf) Here: rf = Risk-free rate = the Treasury bond rate for the period for which the projections are being considered rm = Market return rm -rf = Excess market return ßL = Leveraged Beta CAREER34 LIBRARY © 2005 Vault Inc.
  44. 44. Vault Guide to Finance Interviews Valuation Techniques The value of leveraged Beta can be derived from the unleveraged Beta using the equation below, in a process also referred to as “unlevering the Beta”: ß L = ßU [ 1 + (1 - t) (D) (E) ] Here: ßU = Unleveraged Beta (Again, ßU for a specific company can be obtained from Value Line or online sources like Yahoo!) APV For the APV calculation the discount rate is calculated with the following formula: reU = rf + ßU (rm - rf) Here: ßU = Unleveraged Beta Thus we see the key difference between WACC and APV. With the APV calculation, we take the unleveraged equity discount rate (the discount rate that assumes that a company has no debt), rather than a leveraged (historical) discount rate that the WACC calculation uses. To summarize: Discount Type of Firm Method Beta Rate (Assumption) APV reU all equity ßU WACC reL leveraged/historical ßLVisit the Vault Finance Career Channel at — withinsider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 35
  45. 45. Vault Guide to Finance Interviews Valuation Techniques So suppose a company has debt. Obviously, the APV does not capture the real value of a comapny in this case. Why? Because interest payments are tax deductible. Hence, to find the value of a company using APV, we add in the value of the debt tax shield, or the amount of money a company saves by not having to pay interest on debt. To compensate for this difference we add a value for the debt tax shield separately to arrive at an overall valuation of the company. The debt tax shield (DTS) for any year is given by: DTS = (t)(rD)(D) Here: D = Total debt for the company that year rD = Weighted average interest rate on that debt calculated for each year of the projected cash flows t = Corporate tax rate This principle is the main reason for the emergence of the LBO (leveraged buyout) shops, including Kohlberg Kravis Roberts & Co. (KKR) and its famous takeover of RJR Nabisco, which inspired the bestseller Barbarians at the Gate. KKR borrowed money (issued debt) to buy RJR Nabisco at a price well above the market price. Since the company had no debt before the takeover and has historically had highly reliable cash flows, KKR was able to increase the company’s value through a financial restructuring and save on taxes through the use of interest payments on debt and its accompanying write-offs. The tricky question now is: What discount rate should be used for calculating the present value of the DTS? The answer is the discount rate that would best capture the risk associated with the DTS. If you assume that the ability to use the tax shield is as risky as the cash flows to an all-equity firm, we would use the reU. If you assume that the tax shield is as risky as the ability to repay the debt, then the discount rate should be the average interest rate, or rD. Note: The debt tax shield is similarly calculated for the terminal year and discounted to the present year. APV with DTS = APV without DTS + DTS CAREER36 LIBRARY © 2005 Vault Inc.
  46. 46. Vault Guide to Finance Interviews Valuation Techniques One simple approximation for DTS that can be used for most back-of-the- envelope calculations in an interview is: DTS = APV without DTS X (Tax rate (t) X Long-term debt rate (L)) Here: t = Tax rate L = Leverage ratio (also referred to as the long-term debt ratio) = D/(D + E) The main difference between the WACC and APV methods is that the WACC takes the “target” debt-to-equity ratio to calculate the discount rate. However, a target debt-to-equity ratio is not reached until a few years in the future. Hence the method is not “academically complete.” The APV method takes this into consideration and looks at an “all-equity” firm. However, the difference that amounts from assuming a target debt-to-equity ratio is very small; most investment banks use the WACC method even though most business schools teach both methods. The difference between the two methods will become clearer as we go through an example of how to calculate the appropriate discount rate. Step 1: Assumptions You are given the following information for the company you are valuing: Year 1 Year 2 Year 3 Year 4 EBIT 7.0 7.5 7.9 8.4 Depreciation 2.9 2.7 2.7 2.6 Capital Expenditures 1.5 2.5 2.5 3.0Increase in Working Capital 0.8 1.5 1.5 0.9 Visit the Vault Finance Career Channel at — with insider firm profiles, message boards, the Vault Finance Job Board and more. CAREER LIBRARY 37